India needs new fiscal rules targeting the interest-revenue ratio
he Fiscal Responsibility and Budget Management (FRBM) Act of 2003 aimed for prudence and stability by reducing the Centre’s fiscal deficit (FD) to 3% of GDP by 2008. Alas, the Great Recession struck, forcing a huge expansion of the deficit to support the sinking economy. It proved politically impossible to return to the 3% target, despite much budgetary fudging.
Meanwhile, an FRBM Review Committee proposed a new target: reducing the ratio of debt (Centre and states) to GDP from almost 70% in 2017 to 60% by 2023. This would be achieved by a downward glide of FD to 2.5% of GDP, and revenue deficit to 0.8% by 2023. In crises, the committee felt FD could be higher by 0.5% of GDP.
Can’t Deflate This Balloon
Today, those targets look comic. The Covid-19 crisis has taken the debt-GDP ratio to 88%. FD ballooned to 9.5% in 2020-21, but this included 2% of off-budget borrowing that was brought into the books. Nirmala Sitharaman abandoned the Review Committee’s fiscal target of 2.5%, and now aims for 4.5% by 2025-26. Add another 2.5% for the states and the combined deficit target is 7% of GDP, frighteningly high by historical standards.
But are historical standards now obsolete? The US, Europe and Japan have abandoned traditional fiscal norms in the face of Covid-19, with FDs of 20% of GDP, or more. The Maastricht Treaty of 1993 set a stern FD limit of 3% of GDP for all European members, but has been broken by all. Historically, Germany was deficit adverse, since it remembered how it had suffered hyperinflation through printed money. But massive FDs across the world have created no economic overheating, and inflation remains very subdued.
Larry Summers claims that because of demographic trends, lower productivity and new technology that is less capital-intensive, the world now suffers from ‘secular stagnation’ and a chronic savings glut. Demand is chronically deficient, so printing money no longer stokes demand and inflation. Others like Ruchir Sharma say printed money is inflating the price of assets (shares, real state, gold), though not consumer goods. Paul Krugman has long argued that governments should borrow massively to invest in infrastructure, since this will yield enough returns in the long run to repay the debt.
When interest rates are low and even negative in some countries, the cost of debt servicing has plummeted, and historical benchmarks are obsolete. Carmen Reinhart and Kenneth Rogoff once warned that if a country’s debt-GDP ratio crossed 90%, inflation and soaring interest rates would create havoc. However, Japan’s ratio is now well over 200%, and even the US ratio is over 100%, while inflation remains close to zero. Governments are able to borrow trillions at almost zero interest. This is a new world.
India needs an expert committee to formulate a new fiscal policy in the light of international developments and lessons from the Covid-19 crisis. We can look again at Arvind Subramanian’s note of dissent in the FRBM Review Committee report (bit.ly/3pLnfhg). He said the fiscal flexibility of just 0.5% in crises was much too low, and has been vindicated in the Covid-19 crisis. He argued that having three targets — for debt/ GDP, FD and revenue deficit — were too many, since these could go in different directions. Instead, he suggested one target — reducing the primary deficit — to zero over time.
India’s average primary deficit (FD minus interest payments) has been a whopping 3.2%, making its debt/ GDP ratio exceptionally high and unsustainable.
I did not support Subramanian at the time since I thought the primary deficit was too arcane a concept to be sold to the public. But we need to look afresh at sustainability in an era of lower interest rates. A zero primary deficit means the country is no longer borrowing to pay interest on old debts, and that is certainly one measure of sustainability. But much also depends on the initial ratio, future growth and future inflation.
I suggest a variation of Subramanian’s focus on sustainability of interest payments. The accompanying table shows that the ratio of interest payments to revenue receipts was as low as 10.1% in 1950-51. It had risen to 25.4% when India went bust in1991. It rose further to 36.3% in the pre-Covid year 2019-20, shot up to 44.5% this year, and is projected at a high 45.3% next year. Clearly, far too much revenue is going in servicing old debts. India needs a primary surplus to bring this down.
Since that is an arcane concept, what about setting a target for reducing the interest-to-receipts ratio to 33%? It is easier for the public to grasp that interest on old debts should not exceed one-third of revenue. That, in turn, will imply lower FDs and a primary surplus. Sitharaman’s current projection of a 7% combined central and state deficit by 2025-26 looks alarmingly high. Japan can borrow at zero interest, but Indian gilts still carry 6% interest, which piles up quickly. Let a new expert committee debate this issue and focus on making the interest burden sustainable.